Smart money is betting against the dollar

By Reuters Staff

May 27, 2008

Not long ago, I wrote a post about the dollar’s value and its relationship to interest rates. Part of that piece was concerned with the pressure some countries are feeling to break their currencies’ peg to the dollar, in particular the petro states and China. Their economies are importing dollars by the plane-load, which they receive in exchange for exports to the U.S. These countries maintain a constant–or near constant–exchange rate to the U.S. dollar. This peg enables their export industries to continue profiting from sales to the U.S.

To maintain the peg, they buy up the dollars that flood into their economies with their own currency, flooding their economy with their own currency instead. This maintains the dollar peg, but it sparks inflation in the home currency.

At a certain point, it’s more important to combat inflation than to support export-oriented industry.

And according to the Journal, more hedge funders are making a bet that indeed many of these countries will be forced to break their pegs to the dollar.

Hedge funds and other investors made bundles of money in the 1990s betting currency pegs around the world would break. They are at it again, only this time they are gambling currencies will soar, not plummet.

Among the prime targets are Persian Gulf nations that link their currencies to the U.S. dollar. An economic boom has touched off rampant inflation in these countries. That is putting pressure on policy makers to allow their currencies to strengthen, something they have said they have no plans to do…..

This is more of an existential threat to the American economy. If multiple countries dump their dollar pegs, it could spark a world-wide run on the dollar, which could make many of the exports we’ve come to depend on much more expensive.

………………

Here is another quick explanation of the dynamic at play from an IMF paper that, ironically, was published only a year before the 1998 international currency crisis:

Many developing countries have reaped handsome rewards from surging capital inflows in recent years. This is widely regarded as a very welcome phenomenon, raising levels of investment and encouraging economic growth. But surging capital inflows can also be something of a double-edged sword, inflicting rather less welcome and destabilizing side effects, including a tendency for the local currency to gain in value, undermining the competitiveness of export industries, and potentially giving rise to inflation. Why inflation? Capital inflows result in a buildup of foreign exchange reserves. As these reserves are used to buy domestic currency, the domestic monetary base expands without a corresponding increase in production: too much money begins to chase too few goods and services.

The author was talking about countries like Thailand and Indonesia that benefited from inflows back then. Today the beneficiaries are primarily the petro states and China. The situations are not totally analagous.

At the risk of getting out of my analytical element I would surmise that the capital inflows to the Indonesia, Thailan, et al were more destabilizing than the inflows to China and the Petro states today.

Much of the inflows to emerging markets in the late 90s were due to the purchase of capital and financial assets by investors, which can be sold–sometimes very quickly. When those assets were sold, many of the economies of the Indian Ocean, and their currencies, were decimated. The inflows to China and the petro states are for exported goods purchased by consumers. Oil prices could collapse I suppose, but American consumers can’t return the barrels of oil they purchase from the gulf or the tens of thousands of different products they buy from China. The dollars we’ve sent abroad to purchase goods/services are no longer our dollars.

That’s the big difference here it seems to me. The risk to emerging market economies in the late 90s was that their currencies were OVERvalued and due for a fall. The risk today is that China/Petro State currencies are UNDERvalued.

Despite the differences in the late 90s and today, the paragraph above is still a handy reference to understand one of the key challenges of central banking.

(If there are any Econ PhDs reading today’s blog, I’d appreciate any commentary to let me know whether I’m totally full of it a few paragraphs above!)